Exam 10: Project Cash Flows and Risk

The Unlimited, a national retailing chain, is considering an investment in one of two mutually exclusive projects.The discount rate used for Project A is 12 percent.Further, Project A costs R15,000, and it would be depreciated using MACRS.It is expected to have an after-tax salvage value of R5,000 at the end of 6 years and to produce after-tax cash flows (including depreciation) of R4,000 for each of the 6 years.Project B costs R14,815 and would also be depreciated using MACRS.B is expected to have a zero salvage value at the end of its 6-year life and to produce after-tax cash flows (including depreciation) of R5,100 each year for 6 years.The Unlimited's marginal tax rate is 40 percent.What risk-adjusted discount rate will equate the NPV of Project B to that of Project A?

Corporate risk does not take into consideration the effects of shareholder's diversification; it is measured by a project's effect on the firm's earnings variability.

Whitney Crane Inc.has the following independent investment opportunities for the coming year: The IRRs for Project A and C, respectively, are:

A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.

Exhibit 10-1 You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck.The truck's basic price is R50,000, and it will cost another R10,000 to modify it for special use by your firm.The truck falls into the MACRS three-year class, and it will be sold after three years for R20,000.Use of the truck will require an increase in net working capital (spare parts inventory) of R2,000.The truck will have no effect on revenues, but it is expected to save the firm R20,000 per year in before-tax operating costs, mainly labor.The firm's marginal tax rate is 40 percent. [MACRS table required] -Refer to Exhibit 10-1.What is the incremental operating cash flow in Year 1?

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk.In evaluating this asset, the decision maker should

Tech Engineering Company is considering the purchase of a new machine to replace an existing one.The old machine was purchased 5 years ago at a cost of R20,000, and it is being depreciated on a straight line basis to a zero salvage value over a 10-year life.The current market value of the old machine is R14,000.The new machine, which falls into the MACRS 5-year class, has an estimated life of 5 years, it costs R30,000, and Tech plans to sell the machine at the end of the 5th year for R1,000.The new machine is expected to generate before-tax cash savings of R3,000 per year.The company's tax rate is 40 percent.What is the IRR of the proposed project?

Express Press evaluates many different capital budgeting projects each year.The risks of the projects often differ significantly, from very little risk to risks that are substantially greater than the average risk associated with the firm.If Express Press always uses its weighted average cost of capital, or average required rate of return, to evaluate all of these capital budgeting projects, then the company might make an incorrect decision, or a mistake, by

Which of the following statements is correct?

Net incremental operating cash flow is calculated by adding back the change in depreciation to the change in income after taxes.

After a long drought, the manager of Long Branch Farm is considering the installation of an irrigation system which will cost R100,000.It is estimated that the irrigation system will increase revenues by R20,500 annually, although operating expenses other than depreciation will also increase by R5,000.The system will be depreciated using MACRS over its depreciable life (5 years) to a zero salvage value.If the tax rate on ordinary income is 40 percent, what is the project's IRR?

Using the Security Market Line concept in capital budgeting, which of the following is correct?

The situation where a firm accepts projects to the point where the return on the last project accepted is just equal to or greater than the firm's required rate of return (IRR  k at the margin) is called capital rationing.

Inflation does not need to be built into expected cash flows; the discount rate used in net present value calculations captures the effect of inflation.If you were to include expected inflation into cash flows, all net present value calculations would be incorrect.

Given the following information, calculate the NPV of a proposed project: Cost = R4,000; estimated life = 3 years; initial decrease in accounts receivable = R1000, which must be restored at the end of the project's life; estimated salvage value = R1,000; net income before taxes and depreciation = R2,000 per year; method of depreciation = MACRS; tax rate = 40 percent; required rate of return = 18 percent.

Empirical studies of risk strongly support the contention that investors who are well diversified focus exclusively on market risk when they establish required returns.

The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems.Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs.The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences.System A is judged to be a high-risk project (it might end up costing much more to operate than is expected).The appropriate risk-adjusted discount rate that should be used to evaluate System A is

The beta risk of a project is that part of the project's that cannot be eliminated by diversification.Investors are not concerned about this type of since it cannot be diversified.

If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment.

The stand-alone risk is the risk an asset would have if it were a firm's only asset and it is measured by the variability of the asset's expected returns.